Roth IRA vs. Traditional IRA: Understanding the Key Differences

Have you ever wondered what is the difference between a Roth IRA and a Traditional IRA?  You would not have been the first person to ask.

They can both be effective tools for helping people save money for retirement, but they do have different characteristics. One plan is better for people who are looking to lower their taxable base now, and the other is better for people who are looking to lower their taxable base later.

Let’s take a look at the difference between Roth IRAs and Traditional IRAs.

Traditional IRAs

Traditional IRAs are tax-deferred plans that allow you to make contributions from your pretax income. This has the effect of lowering your taxable income and allowing you to gain tax free growth. Traditional IRA account holders pay less in taxes today based on the hope of taxes being at a much lower rate in the future.

To qualify for a Traditional IRA, you have to meet two criteria. First, you must be under the age of 70 ½.  Secondly, you must have some documented form of compensation. Contributions are maxed at $5,000 for anyone under the age of 50 or $6,000 for anybody 50 and over.

Since Traditional IRA account holders do not pay taxes on their contributions, they do have to pay taxes on their withdrawals. Account holders are required to start taking minimum distributions on their funds by the age of 70 ½. All withdrawals are subject to the income tax rates of the time they are taken out.

Roth IRAs

Roth IRAs are tax-advantaged plans in which you forego a tax deduction today to withdraw your money tax-free down the road. All contributions are made from after-tax income. In general, Roth IRA account holders prefer to pay their taxes today since they believe that tax rates will be higher in the future.

To participate in a Roth IRA, you just need to have some documented form of compensation. This can be in the form of wages, tips, or even alimony.  Just like with a Traditional IRA, you can contribute up to $5,000 a year if you are below the age of 50 or $6,000 annually if you are older than 50.

Roth IRA vs. Traditional IRA

One big difference between Roth IRAs and Traditional IRAs is that all earnings and contributions taken after the age of 59 ½ are income tax-free with a Roth IRA.

Also, with a Roth IRA, you can take out your own contributions penalty-free at any time.  For example, if you contributed $5,000 a year for three years and had $16,500 total when a big emergency hit, you could withdraw up to $15,000 penalty-free.  The trick is that you can’t pay yourself back, though, after making an early withdrawal.

Finally, there are no required distributions for Roth IRAs.

I personally contribute to my 401(k) and a Roth IRA.  In fact, my husband fully funds a Roth IRA, too.  We figure that diversity is a good thing in most aspects of life – especially when saving for retirement.

Do you contribute to a Traditional IRA or a Roth IRA?  What do you think about them?

Crystal Stemberger

Crystal Stemberger writes about finding the balance between paying the bills, saving for the future, and budgeting for the fun stuff at the aptly-titled Budgeting in the Fun Stuff.

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